The branch profits tax - traps for the unwary.

Prior to the Tax Reform Act of 1986 (TRA), foreign corporations could face significantly different tax consequences on the distribution of U.S. profits. A domestic subsidiary was subject to a 30% (or lower treaty rate) withholding tax on the remittance of earnings to its parent. Profits from a branch office, however, could be repatriated to the foreign home office without being subject to the additional withholding tax. (A second-tier withholding applied to subsequent distributions by the foreign corporation if certain conditions were met, but the availability of exemptions, treaty reductions and general enforcement difficulties made the effectiveness of this withholding problematic.) To eliminate the disparity, the TRA created Sec. 884, imposing the so-called branch profits tax (BPT).

Sec. 884 attempts to put a foreign branch operation on the same tax footing as a foreign subsidiary. This is accomplished by determining the amount of U.S. earnings theoretically "repatriated" to the foreign parent/shareholders by the branch. To determine this amount, Sec. 884 looks to the "U.S. net equity" of the branch at the beginning and end of the tax year. If this amount has decreased (and is not attributable to an operating loss), there is deemed to have been a repatriation of funds. If post-1986 current or accumulated earnings and profits (E&P) exist, the BPT is imposed on this "dividend equivalent amount," theoretically equalizing tax treatment of the domestic branch and the domestic subsidiary.

There are problems with this approach both as to the underlying theory and the practical application of the provisions. The mechanical manner in which the tax is determined provides many traps for the unwary. Some, but certainly not all, are discussed below.

Definitions and determination of tax

To determine the BPT, one must define certain terms. Regs. Sec. 1.884-1(b) defines the following:

* Dividend equivalent amount (DEA): A foreign corporation's effectively connected earnings and profits (ECE&P), either:

1. reduced for increases in U.S. net equity (but not below zero), or

2. increased for decreases in U.S. net equity, with such increases limited to the foreign corporation's accumulated ECE&P (AECE&P) as of the beginning of the year.

* Effectively connected income (ECI): Income effectively connected with the conduct of a trade or business in the United States.

* Effectively connected earnings and profits: E&P as determined under Sec. 312, with certain modifications, attributable to ECI.

* Accumulated effectively connected earnings and profits: The aggregate amount of ECE&P for preceding tax years beginning after Dec. 31, 1986, minus the aggregate DEAs for such preceding years. The AECE&P may be less than zero.

* U.S. net equity: The aggregate amount of a foreign corporation's U.S. assets as of the determination date, reduced by the U.S. liabilities as of the same date.

* U.S. asset: Generally, an asset held by the foreign corporation as of the determination date for which all income produced by the asset and all gain from the disposition of the asset would be ECI.

* U.S. liabilities: Generally determined under the regulations of Sec. 882, under which the U.S. liabilities are defined as the product of the ratio of U.S. assets to total assets, multiplied by the total liabilities. An election is available that may serve to reduce this amount.

The example on page 748 demonstrates an important characteristic of the BPT. Note that a tax is incurred, although there is no mention of a distribution; indeed, none is required for the tax to apply. Any decrease in U.S. assets or increase in U.S. liabilities may create a DEA, triggering the tax.

Potential traps--operating years

* Failure to use E&P basis for determining DEA: A foreign corporation may be exposed to the BPT even if it has never incurred a regular corporate tax and has a substantial net operating loss (NOL) carryforward available. This results from the differences in determining taxable income and ECE&P. Notable among these is the adjustment required for real property placed in service prior to 1987. Foreign corporations holding such property must carefully investigate the BPT implications.

* Failure to recognize second-tier withholding requirements: If a foreign corporation is not exposed to the BPT (e.g., due to treaty relief), distributions made with respect to earnings are subject to the pre-1987 second-tier withholding rules. This withholding also applies to distributions made from AE&P attributable to periods prior to 1987.

* Failure to account for partnership, estate or trust: A foreign corporation that is a partner in a partnership conducting a U.S. trade or business will be considered as being in a U.S. trade or business itself. Consequently, the partnership's passthrough items may be ECI and create a corporate-level DEA subject to the BPT. Similar rules apply for trusts and estates.

* Inadvertent creation of DEA: As noted earlier, it is not necessary to make a distribution to trigger the BPT. Any change in U.S. assets or U.S. liabilities resulting in a decrease in U.S. net equity creates a potential tax.

A foreign corporation that has accumulated cash must be careful. Cash maintained in a U.S. bank or depository institution should be a U.S. asset. However, funds moved offshore or to a nonqualifying institution will most likely not be considered as a U.S. asset, causing a reduction in U.S. net equity and triggering a potential BPT. Should the corporation invest the accumulation in marketable securities, only the amounts so invested that are required to meet current operating requirements--determined as of year-end--will be treated as U.S. assets. Any excess will be a non-U.S. asset.

To avoid this result, the foreign corporation may consider reinvesting the funds in other U.S. assets. While this may be sufficient, care must be exercised. Stock of a foreign corporation, even though it holds only U.S. assets, is not itself a U.S. asset. Furthermore, a U.S. real property holding corporation does not qualify as a U.S. asset, even though it is a U.S. corporation holding U.S. property. Finally, unimproved investment real estate within the United States is not considered a U.S. asset if it is not income-producing. The determination of what constitutes a U.S. asset is neither intuitive nor straightforward. If in doubt, Regs. Sec. 1.884-1 should be consulted.

A particularly subtle effect on U.S. net equity may result from the definition of U.S. liabilities. These liabilities are determined by multiplying the total liabilities by the ratio of U.S. assets to total assets. However, the values used for the asset ratio are determined under Sec. 882, which uses a fair market or regular tax basis (as opposed to an E&P basis). A disproportionate increase in the fair market value of U.S. assets may cause a corresponding increase in U.S. liabilities under Sec. 884, without a corresponding increase in U.S. assets (for Sec. 884 purposes), thereby decreasing U.S. net equity. The result is a potential BPT.

* Not electing to reduce U.S. liabilities: The final regulations provide a method to possibly avoid this situation by permitting an election to reduce the computed U.S. liabilities to (but not below) the amount actually reflected on the foreign corporation's U.S. books. The effect is to cause an increase in U.S. net equity. However, the interest deduction attributable to the liabilities so reduced is not allowed. Furthermore, once the election is made, it must be repeated in subsequent years. Failure to do so will reverse the effect, creating a decrease in U.S. net equity that may generate a BPT.

Potential traps--liquidation

To be consistent with the Code provision allowing the tax-free liquidation of a domestic subsidiary, Sec. 884 provides that there generally will be no BPT imposed in the year of termination of the branch. Although apparently straightforward, this termination exception contains traps as well.

* Retention of U.S. assets at year-end: To use the exception, the foreign corporation must own no U.S. assets at year-end. This may cause problems. For example, if the foreign corporation sells U.S. real estate and takes back an installment note, it may wish to report income on the installment basis. However, this will cause the note to be treated as a U.S. asset (since it will be generating taxable U.S. income) and will prevent the corporation from using the exception. Electing out of the installment method, while solving the BPT problem, may be equally objectionable, since it will require current taxation of the entire gain.

* Reinvestment of property in U.S. assets: The rules under Sec. 884 prohibit the reinvestment of liquidation proceeds, in any form, in the United States for a three-year period. Strict "tracing" rules are applied. Furthermore, to assist the IRS in determining whether such prohibited transactions have occurred, the foreign corporation must agree to extend the statute of limitations from three to six years.

* Exceptions to the nontaxability provision: Certain types of AECE&P will not escape the BPT on liquidation even if the termination election applies. ECE&P that has been accumulated, but not subject to the BPT because of the election to reduce liabilities, will be subject to the BPT on termination. Similarly, any ECE&P accumulated in a trust will also be subject to the BPT on termination.

* Watch for Sec. 899: Congress on several occasions has attempted to impose a corporate-level tax on the liquidation of a domestic subsidiary. The proposed changes, incorporated in a new Sec. 899, have been defeated each time. However, should Sec. 899 be enacted, the theoretical underpinnings for the liquidation exception will be gone and so will, most likely, the exception itself.

The branch profits tax of Sec. 884 is a cumbersome, mechanical attempt to impose the equivalent of shareholder taxation on the U.S. earnings of foreign corporations' branch operations. As such, it has all the expected complications and traps one would expect. Its application should be approached with caution.

Example: Calculation of DEA and BPT

For simplification, assume that all assets and liabilities are U.S. assets and liabilities, the corporation had $10 of ECE&P for the year, and there is no treaty relief from the BPT.

                                   Beginning   Ending
Assets:
Cash                                 $ 10      $  5
Accounts receivable                    15        10
Inventory                              35        25
Real property used in U.S. trade      140       140
Total assets                          200       180
Liabilities:
Accounts payable                     $ 30        20
Mortgage payable                      120       130
Total liabilities                     150       150
U.S. net equity                      $ 50      $ 30

The DEA is $30 ($10 ECE&P + $20) (the decrease in U.S. net equity)). Since this amount is less than the AECE&P as of the beginning of the year, the 30% BPT is imposed, resulting in a tax of $9.